Wednesday, 8 May 2013

Austerity is not killing the patient, lack of reform is.

Prologue

A junkie is forced into rehab in order to save his life. As the withdrawal
symptoms kick in, he starts to scream with pain and curse the moment when he
agreed to seek help. As an uninformed witness, you might feel sorry for
him and brand the treatment as torture. Surely it is inhumane to let him go
through such a pain, isn't it? Well, no. It is not. The pain is a result of his
addiction and blaming the cure would be a mistake. Yet this is exactly what is
happening in Europe. After decades of debt addiction, the European economies
are struggling with the withdrawal symptoms and are blaming austerity for the
pain.

However, there is a blame that can be laid at the doctors treating the
European patient. The treatment could be more effective if other problems
are also tackled yet this means even more pain in the short term. The austerity
treatment prescribed to the European economies should be accompanied by an
equally painful dose of reform. Structural reconstruction is as necessary as
austerity and it is this exact reform that would bring back the solid growth policy
makers desire so much.

How Austerity (kind of) worked

Since the beginning of the crisis, 5 of the 17 Eurozone countries - so far - have run
into significant financial problems and were forced into asking for EU and IMF
help . In exchange for support, these countries have signed up to a painful
program of austerity and reform. Cuts and tax hikes have hit hard yet reforms
have barely been started. Because of external factors, in most of the EU countries
the economic activity is now reaching pre-recession levels. While most financial
indicators have stabilised -Ireland has even managed to exit the bailout
program - the social pain is only now starting to hit. Unemployment is the clearest
sign of this pain: record 12.1% Eurozone unemployment, 10.9% for the EU. 26.7%
for Spain, 28% for Greece, 17.5% for Portugal. 24% of EU youth unemployed, 56% youth unemployment in Spain and 60% in
Greece.64%in Greece, 42% in Portugal (new figures released a few hours ago)

It is in this context that a significant
majority of voices are warning that austerity has not helped Europe and that it
has actually made things worse. Indeed, many of the fundamentals that the
austerity policies have been based on have proven to be false. The now famous Reinhard
and Rogoff excel mistake and acknowledgments
from the IMF that they have underestimated
the fiscal multipliers of budget cuts have embarrassed the European Commission who is left without the two big arguments it had in pushing austerity.

However, it is important to remember
that austerity was not only adopted because of economic reasons. The high-politics
game played at EU Councils resulted in countless agreements, all saying the
same thing: Northern countries and the Commission would help Southern countries
escape bankruptcy if these countries put their budgets in order and reform so
they close the competitivity gap. It is interesting to note that before and
immediately after the fiscal compact of March 2012, media kept referring to
these adjustments as ‘budget balancing’ and ‘fiscal discipline’. Today, the
same measures are being labelled as ‘austerity’.

The intention of these programmes was dual: on
one hand, countries which lagged behind were supposed to become more
competitive and, as such, make Europe as a whole stronger. Secondly, a chance
for political compromise and a show of unity to reassure the markets was only possible
if the Northern countries could present a deal acceptable to their electorate.
It would have been impossible for Angela Merkel to pass a bailout deal without
having anything to show for it.

It is this precise political factor
that many of those who condemn austerity are now ignoring. At the height of the
crisis, the political fractures of the Union were as a big of a risk to the EU
economy as the recession itself. Widely divergent government debt yields were a
sign of a fractured EU. And this fracture was obvious not just in economic
indexes but in the philosophy behind policy as well. As Italian PM Monti very
correctly underlined: "For Germany, economics is a
branch of moral philosophy”. Transferring bailout money to countries that have
broken this moral code without any strings attached would have created a ‘moral
hazard’ that would have been unacceptable to the Germans. The only possible
agreement included both money transfers (solidarity asked by South) and reform
(budget balancing asked by North). Without a political agreement, the markets
would have continued to take advantage of the cracks of the Eurozone pushing Italy
and Spain to encounter problems in selling their debt. Furthermore, current
criticism directed at austerity assumes that Mario Draghi would have made his ‘whatever
it takes’ promise to save the euro – widely credited with saving Italy and
Spain from the brink - even in the absence of deficit cutting measures, which I believe to be very unlikely.

Was it fair for the EU to impose such measures on the Southern countries? If you consider the alternatives, either bankruptcy or an exit from the eurozone ( as bad as a bankruptcy, if not worse), the current social problems and unemployment levels are quite modest. Equally telling is the fact that real unemployment figure (not just benefits claim, implied for an average workforce participation of 65%) is close to 12% in the US - a country that has applied the exact opposite cure to its economic problems. In effect, there is very little to show for the stimulus in the American economy other than significant increases in inequality (with the top earners benefiting the most from it) and debt levels.

But nothing has
changed

While the high politics succeeded in
reaching an agreement and the EU delivered on its promise to bail out countries
in need, local politics failed to implement their promises. Reforms have been
painfully slow exacerbating the pain caused by austerity. After six years of
recession, it was only in the last week of April 2013 that Greece has voted
into law part (not all) of the labour reform agreed in the first bailout. Greece
and Cyprus are still having problems identifying property rights for much of
the countries’ land because there is no clear record. In the last report on the
EU economy, the IMF has yet again assessed that there has been no progress in
tackling ‘notorious’ tax evasion in the South of Europe. The tax administrators
in Cyprus, Italy and Greece are still politically named. The Spanish banking
system has not yet been cleared of bad loans and new loans are very much
impossible to get, asphyxiating the creation of new businesses and jobs. Even
reforms that have been adopted are now at threat. The new Italian government is
being forced to roll back some of Monti’s reforms, like the property tax, at
the request of Berlusconi, the new voice of anti-austerity in the country.
Italians seem to have forgotten the country’s performance under Berlusconi when
Italy's economy grew least in the world for a decade, bar Haiti and
Zimbabwe, and reached the third highest debt-to-GDP level.

It is hard to say how much lower unemployment
would be today if aggressive reforms would have actually been implemented. It
is very possible that unemployment would have actually been higher as reforms
would have also caused some extra pain to the economy but I can't see how
the number of long term unemployed would have been as high as it is now. Undoubtedly, the
EU would have been in a better position to deal with future problems.

Essentially, very little has
changed. Austerity has forced an
internal devaluation and made southern countries slightly more competitive but
there has been very little structural change. And the incentive for reforms is receding.
While central banks are flooding the market with money and public dissatisfaction
is causing social convulsions, governments around Europe are mistakenly looking to change course. There is little talk of stimulus as most commentators
realise that is not acceptable for the Germans, but easing austerity is well
under way. Unfortunately, the reform programs have also been eased.

Epilogue

After a few days in rehabilitation,
the junkie exits treatment and goes back into the world. As there was no appropriate
psychological support provided during treatment, the patient doesn’t change his
life habits and is soon back on drugs. The treatment fails. At the
hospital, one of the doctors that
treated the patient, Ms Dorothea, is facing an inquiry into her treatment which
was described as ‘brutal’ and ‘inhumane’ by her colleague, Mr Silvio. Mr Silvio
is the one who recommended a priest to help the patient change his lifestyle.
The story doesn’t end.